I’m torn on this one. By any objective measure, the deal is really, really bad public policy. And the one thing that really scares me about failing to reach a deal — defaulting on Treasuries, which would be beyond catastrophic — has been taken off the table by the Treasury, which said that it will prioritize interest payments.

The relevant question in this situation, however, is whether a revolt by House Democrats could move the bill to the left. I think it could, but it unfortunately depends on what the Tea Party freshmen do. The way I see it, the only way the deal moves to the left is if it fails in the House because of a significant Tea Party revolt.

If Boehner loses so many Tea Partiers that he can’t possibly expect to win them back, then his only option will be to pass a bill with the Dems. If that happens, then the Dems could — and should — extract significant concessions from Boehner in exchange for their support. And I think Boehner would absolutely be open to making significant concessions. When Boehner was whipping for his bill last week, he was telling Tea Party freshmen that if his bill failed, then he was going to introduce a clean debt limit bill and pass it with the Democrats and 30 moderate Republicans.

I still think Boehner can be forced into that position — but only if there’s absolutely no chance that he can win enough Tea Partiers to pass a bill with just Republicans. If the deal fails in the House because something like 5–7 Tea Partiers vote no, then Boehner can still probably pick off enough Tea Party holdouts to pass the bill on a second try. But if the deal fails and Boehner loses 20–30 Tea Partiers, then there are no changes that he could realistically make to win them back. His only option would be to pass a bill with the Dems and 30 moderate Republicans. (And yes, I think the Senate will pass whatever deal the House sends them. McConnell would pass a clean debt limit bill if he really had to.)

So at this point, I think House Dems should vote against the debt limit deal. If Boehner/Cantor/McCarthy have enough juice to pass the deal with just Republicans, then good for them. Make them own it though. I’m sure a few conservative House Dems (e.g., Shuler, Matheson) will vote for the deal, but hopefully Pelosi can hold the line with the rest of the caucus.

For Dodd-Frank’s one-year anniversary, I did an interview with Mike Konczal on how the first year went. You can read the interview here. Unlike the vast majority of commentators who have been talking about Dodd-Frank this week, I’ve been following the rulemaking process very closely (as regular readers know), and I have some positive things to say.

You should also read Mike’s interview with Marcus Stanley, who is the legislative director for the progressive group Americans for Financial Reform. Like me, he’s intimately familiar with the Dodd-Frank rulemaking process, and he also has positive things to say. Funny how that works!

The idea that Republicans in congress were going to force big cuts in the country’s most important programs – social security, medicare, and medicaid – by taking Wall Street hostage with the debt ceiling is absurd. It was only necessary for President Obama to call their bluff.

The bottom line is that the debt ceiling is a gun pointed first and foremost at Wall Street’s head. And, there is no way on earth that Wall Street is going to let the Republicans pull the trigger.

This is silly. “Wall Street,” by which Baker means the major banks, has very little sway over the 87 Tea Party freshmen. It’s the GOP freshmen who are currently the key constituency in the debt ceiling negotiations, and if anything, most of them would take pride in rejecting impassioned pleas from JPMorgan and Goldman Sachs. The idea that the major banks can just snap their fingers and get the Tea Party freshmen to drop their debt ceiling demands is beyond ridiculous. The Tea Party freshmen are thoroughly crazy, and there’s no telling what they’ll do. But if you think they’re all tools of Wall Street, then you simply haven’t been paying attention.

Of course, making this argument allows Dean to — what else? — blame Obama, this time for not “calling their bluff.” (It’s easy to call bluffs from the sidelines, isn’t it?) Which, let’s be honest, was the point of his column anyway.

What are we to make of Obama’s “grand bargain”? My initial reaction to the news that Obama was putting Social Security and Medicare cuts on the table was despair. What was/is the White House thinking? Obviously, no one outside the White House knows for sure, but I think I have a pretty good idea.

As I said in a DM exchange with Mike Konczal on Wednesday night, I think the White House is trying to scare Democrats into accepting a deficit reduction deal with little or no revenue increases. I think Boehner can’t get the votes in the House for a deal that includes any revenue increases, and I think the White House knows it. They know that the final deal will end up being 100% spending cuts. The problem with this is that it might not get enough Dem votes to pass — especially if Dems on the Hill are obsessing about the ratio of spending cuts to revenue increases throughout the negotiations.

So in order to retain enough Dems, the White House needs to make sure that the $2 trillion, all-spending-cuts deal is the “compromise” position. If the alternative is an even larger deficit reduction deal that includes savage cuts to Social Security and Medicare, then plenty of Dems will be downright eager to vote for a deficit reduction deal that doesn’t touch Social Security or Medicare, even if it is 100% spending cuts. If you know that the final deal will be 100% spending cuts, then you don’t want the Dems to make their “line in the sand” the inclusion of revenue increases. By putting Social Security and Medicare on the table, you allow the Dems to make the protection of those programs their “line in the sand,” rather than the inclusion of revenue increases. And that will free enough Dems up to vote for the final, all-spending-cuts deal.

This would also explain why Obama is still saying that he wants a “grand bargain,” even after Boehner said that they should focus on the smaller deal that the Biden-led group had been working on — for the strategy to be effective, the grand bargain needs to continue to be a viable option (that the Dems are afraid of).

Now, we can argue about whether Obama truly wants to strike a “grand bargain” that cuts Social Security and Medicare. I don’t know if he does, and neither do you. (It’s certainly possible that he does, but again, I don’t know.) However, I think that question, interesting though it may be, is ultimately irrelevant. Even if Obama truly does want a grand bargain, there’s simply no way that he thinks they can agree on $1 trillion in tax increases, and an overhaul of Social Security, Medicare, and Medicaid, all in under 2 weeks. Purely as a legislative matter, it’s almost an impossible task, which I’m sure Phil Schiliro would have explained to him. So really, the only way the “grand bargain” makes sense is if it’s a negotiating strategy.

And if this is a negotiating strategy, the best explanation is that the White House is using the threat of Social Security and Medicare cuts to scare Democrats into voting for an all-spending-cuts deal.

Risk has an interesting article ($) on the plans by some dealers to offer “collateral transformation” services to derivatives end-users. Requiring most derivatives to be cleared means that end-users will have to post daily variation margin to the clearinghouse (or “CCP”). Here’s how Risk describes the problem:

The problem centres on the type of collateral required by CCPs — or more specifically, the fact that many end-users don’t hold enough of it. Clearing houses only accept cash for variation margin, and usually insist on cash or sovereign bonds for initial margin. However, many buy-side users of derivatives tend not to invest in these assets — at least, not in the amounts that might be necessary.
...
Clearing members [i.e., the dealers] say they have a solution. ... [C]learing members are responsible for collecting margin from their clients and posting it to the clearing house, charging a fee for the privilege. As an additional service, however, a number of clearing members are also planning to offer collateral transformation facilities — essentially, enabling the client to post non-eligible instruments with the dealer, which will be switched into cash via the repo market and then posted with the CCP.

So the plan is to concentrate liquidity risk at the dealer banks? Gee, what could possibly go wrong?

In all seriousness though, this is something that regulators should pay very close attention to. It’s easy enough* for dealers to tell regulators that their exposure is limited because the agreements are “unconditionally revocable” — that is, the dealer can unilaterally refuse to fund the client’s variation margin if the markets get too rough, and can demand that the client put up the cash. But it’s not nearly as easy for the dealer to tell its big hedge fund and pension fund clients to take a hike during a crisis. Think about it. If, say, Morgan Stanley refuses to fund a client’s variation margin call when the markets get volatile, the client will (a) be pissed, and (b) will start thinking, “What’s going on here? Is Morgan Stanley having trouble accessing the repo markets? If they can’t fund themselves in the repo markets, how much longer can they stay in business? Shit, I better pull my prime brokerage account at MS.” Then the run begins.

I’m not saying that no dealer would ever be able pull the trigger and refuse to fund a client’s variation margin. I’m just saying that this kind of arrangement could very easily turn into a non-contractual commitment to meet clients’ variation margin calls during a crisis. And that would undermine the dealers’ inevitable argument about how the unconditionally revocable nature of the arrangements means that the liquidity risk would be pushed back onto the clients — and away from the dealers — during a crisis.

So what should regulators do about “collateral transformation”? Well, for one thing, they should treat collateral transformation very harshly in Basel III’s Liquidity Coverage Ratio (LCR). Since these arrangements would almost certainly be structured as unconditionally revocable, they would be considered “Other Contingent Funding Liabilities” under the LCR. The run-off rate for “Other Contingent Funding Liabilities,” which determines the size of the liquidity buffer the dealers would have to hold against their collateral transformation arrangements, has been left to the discretion of national regulators. In addition to the run-off rate, national regulators also have to come up with assumptions for how much clients’ variation margins could move against dealers in the LCR’s 30-day stress scenario.

The safest route would be to set the run-off rate at 100% — that is, to assume that the dealers will fund 100% of clients’ variation margin through their collateral transformation services. A 75% run-off rate would probably be appropriately prudent as well — dealers will probably be able to say no to at least some clients, and will likely come up with other ways to mitigate some of the risk to themselves.

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* Actually, drafting and negotiating these types of contracts is a fiendishly difficult and contentious process, but that’s neither here nor there.

About Me

I'm a finance lawyer in New York. I used to focus on derivatives and structured finance (you know, back when there was a structured finance market). I spent the majority of my career at one of the major investment banks. My background is in economics and, unfortunately, politics.

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